Fraud worries grow for private equity deals in Asia

Private equity investors in Asia are increasingly fearful of fraud within their portfolio companies as the global economic downturn puts mounting pressure on firms in the region.

The global financial crisis has already caused significant damage to private equity-backed companies in Asia, with shares plunging and demand drying up for everything from electronics to manufactured goods. But corporate fraud, a scourge that can be more prevalent and harder to detect in emerging economies such as China and India, can quickly turn a bad private equity investment into a disaster.

The collapse of shares in India’s Satyam Computer Services last week after its chairman disclosed inflated earnings shocked shareholders and global markets, and served as a reminder of the pitfalls of investing in emerging markets. Private equity firms were believed by investment bankers and analysts to have been eyeing an investment in Satyam late last year.

“Satyam is a story about fraud, and that isn’t unique to emerging markets. What is unique to these markets is a generally accepted understanding that private equity firms here manage for a very different risk and reward equation,” said David Legg, managing director for Asia and Europe at Gerson Lehrman Group. Gerson Lehrman provides research on deals to banks such as Credit Suisse, buyout firms and hedge funds.

“You can always use a second opinion from someone who has real expertise. Asia seems to have more examples of why that second opinion is so essential,” said Legg, whose firm’s Asia business grew 90% during 2008. In China, Beijing-based Asia Media Co was forced to delist in September from the Tokyo Stock Exchange after its founder and former top boss resigned, saying he had misallocated capital from the company.

Asia Media was one of the early bets in China by US venture capital fund Sequoia Capital, which helped the firm to become the first Chinese company to list in Tokyo. “The risk of fraud is higher in Asia,” said Jack Clode, managing director of Kroll Inc., a risk consulting company owned by Marsh & McLennan. “When the market is booming, clients don’t consider (fraud) as a serious issue,” he added.

Clode, based in Hong Kong, said Kroll’s post-transaction investigation business has grown 25% in Asia since September, due in part to private equity-type investors fearful of what they may find.

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Private equity firms from New York to London invested billions of dollars across Asia in the last few years in a rush to tap the region’s economic growth. That expansion has slowed, leaving some investors worried that managers will resort to cooking books to keep top executives and key shareholders happy.

In addition, before the financial crisis hit, several auctions brought stiff competition by private equity bidders gunning for assets. That kind of competition can cause a firm to rush due diligence in order to seal the deal. One of the first steps a private equity investor implements is making sure that the incentives of their operational managers are tightly aligned with the portfolio company’s success.

That can work to a firm’s advantage when the economy is humming. But when things slow, that approach can backfire. “If you push management in the wrong direction, that creates an environment where fraud can happen,” said Tadashi Kageyama, regional managing director for Japan and South Korea at Kroll. “Firms that were under time pressure, that are now having post-deal issues. That’s what is keeping us busy,” he added.

In November, TPG Capital ran into legal trouble with its portfolio company Nissin Leasing (China) Co Ltd after Nissin’s former management was replaced by TPG representatives amid disputes over control of the Shanghai-based firm, according to Chinese media reports. In a sign that private equity and other corporate buyers are taking the issue seriously, Kroll’s investigative work is up 25% across Asia, Kageyama said, adding that the firm has doubled its China staff in the last 18 months. (Reuters)

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